Guidance

Deferred Compensation Rules Could Help You Attract, Retain Talent – If You Do It Right

Deferred compensation plans let employees put off receiving wages they’re earning now – so they can (hopefully) be taxed at a lower rate down the road. Deferred compensation also helps employees save their wages for years when they otherwise wouldn’t be earning as much (like at the end of a contract or after retirement) or for years when they anticipate big expenses (like when a child starts college or university). Save money and potentially pay less in taxes – what’s not to love?

As an employer, offering a deferred compensation plan can make a big difference in your ability to attract and retain employees and independent contractors. It also allows you to keep the money you would otherwise pay them until the deferral period is over, while your employees can postpone paying the income taxes.

But the rules governing deferred compensation can put a damper on those plans and drastically affect your employees’ tax bills if the rules aren’t followed. Putting a deferred compensation plan in place isn’t as simple as just promising to pay your employee at some future date.

In order for compensation to be deferred, it has to meet certain requirements. For example, most people are familiar with qualified requirement plans, such as 401(k) plans. These retirement plans are a form of deferred compensation. However, retirement plans have limits on how much you can deposit in them, and highly compensated employees may want to defer more income than they can under the rules that apply to these plans.

Nonqualified deferred compensation plans may meet the needs of these highly compensated employees. But, if your plan isn’t set up properly and administered the right way, the income is taxed immediately instead of at that time down the road when the employee receives it. But it doesn’t stop there. An additional 20% tax is assessed and an interest rate premium tax may be also due.

Substantial Risk of Forfeiture – and the Effect on Deferred Comp

Some, but not all, deferred compensation arrangements are subject to a substantial risk of forfeiture (“SRF”). But what is the effect of a substantial risk of forfeiture? And how do you know if you have one?

An employee generally does not recognize income that is subject to SRF that was established before the work was performed. But, sometimes the employer and employee agree to extend the period of time that the risk of forfeiture applies.

An additional risk of forfeiture only extends the deferral of tax if the present value of the amount to be received (and that is subject to an SRF) is “materially greater” than the present value of the amount that otherwise would have been received.

A substantial risk of forfeiture can be based on either time or performance metrics that the employee has to meet in order to receive their deferred compensation. But in either case, whether or not compensation is subject to a substantial risk of forfeiture comes down to a facts-and-circumstances determination. So, if you’re working to design a plan with a substantial risk of forfeiture, consider including one or more of certain time- and performance-based conditions, such as:

How long the employee will need to work for the organization

Whether or not the employee will have personal performance goals to meet

Whether or not organizational goals will need to be met

What activities the organization will need to engage in

The first item in this list is a time-based condition and the last three are all performance-based conditions. While the organizational goals aren’t completely within the individual’s control in the same way personal performance goals would be, the prevailing logic is that the employee is still responsible for contributing to the organization’s performance and helping it to achieve its objectives.

Once the risk of forfeiture has been established, the next step is to determine whether or not the risk is substantial. In other words, how likely is it that the criteria will not be met and the compensation actually forfeited? If there is doubt that the employee will actually receive the compensation, then the risk of forfeiture is considered substantial.

What Has Changed?

In the situation addressed by the IRS, an employer allowed an employee to defer a portion of his salary. Under the agreement, the employee’s salary was reduced by $600 in each biweekly pay period ($15,600 annually). The employer agreed to match 25% of each salary reduction ($150 per pay period, or $3,900 per year) for a total deferral of $19,500 for the year. The entire $19,500 would be paid to the employee at the beginning of the third year after the year of deferral, provided that he continued to provide services throughout the intervening period.

The IRS concluded that the amount that the employee deferred was subject to a substantial risk of forfeiture under section 409A, because the matching contribution provided by the employer resulted in a 25% increase in the present value of the amount deferred. In other words, a 25% increase in the present value of the amount to be received was deemed to be a material increase. Thus, the otherwise vested salary was considered subject to a substantial risk of forfeiture.

We now know that the current position of the IRS is that if the present value of the benefits that will be paid is at least 125% of what the employee otherwise would have received, it is a “materially greater” amount. Recently proposed regulations that are applicable to deferred compensation provided to employees by tax-exempt organizations provide guidance on how to calculate this present value.

What Does This Mean to You?

The obvious takeaway from this CCA is that an employee can defer a portion of her compensation and receive a 25% match from her employer. But there is also a second, less obvious application of this ruling.

Sometimes employers and employees want to extend a risk of forfeiture to further delay the time when an employee’s deferred compensation is actually recognized as income. They do this by adding a new risk of forfeiture just before the initial service requirement is satisfied.

This technique can be effective if the present value of the amount subject to a substantial risk of forfeiture is “materially greater” than the present value of the amount the recipient otherwise would have received. But until now, there was no guidance as to what would be considered to be materially greater in this context. Based on this CCA, a substantial risk of forfeiture can be extended or modified with less worry that you’ll run afoul of the rules regarding nonqualified deferred compensation.

An even safer option is to mirror the proposed regulations issued this summer with respect to deferred compensation plans offered by tax-exempt employers and governments. These proposed regulations incorporate the same guidance as the CCA with respect to the present value of the amount to be received by the employee. They also require that the agreement to extend the deferral period be entered into at least 90 days before the original risk of forfeiture would have expired. The third requirement is that the employee must be required to perform an additional two years of service.

The Takeaway

As you review prior year operations now or in the coming months, take some time to review your compensation arrangements, too. How were operations? Did you have the talent you needed to achieve peak performance? Since compensation is tied to your operations in many ways, are those relationships between compensation and operations still supporting each other successfully? Are you going where you want to go?

Remember to review all compensation and benefit plans you have in place to make sure they are operating as they were designed to and that you are in compliance with all regulatory requirements. This review should include both qualified and nonqualified plans.

Successful companies also think outside the box when it comes to compensating key employees. Sometimes a nonqualified deferred compensation plan can help you attract and retain important talent by providing performance incentives and supplemental retirement income.

Could you use some help reviewing your compensation arrangements and employment contracts? Do you want to know if your plans comply with current rules and attract and retain the kind of talent you’re looking for? Or maybe you’d like to compare plans to see if there’s something better and more competitive you could be offering your employees.